The Tax Cuts and Jobs Act is the biggest U.S. tax bill in over thirty years. It cut corporate tax rates to increase business income and for many business owners opportunities to save on taxes. For individuals who have considered starting a business, now is a great time, as there are several incentives to make the leap into entrepreneurship.
If you are a business operating as a C corporation, under the new law, tax season has become considerably easier. There’s now a single flat rate of 21% that applies from your first dollar of income to your very last dollar of income. This makes C corporations far more valuable to business owners.
For example, an owner with a taxable income in the 22% bracket or above can earn income inside a C corporation, pay tax at the 21% flat rate, and leave the net profit inside the corporation until death, when the corporation will acquire a “stepped-up basis” and be liquidated and distributed tax-free to heirs.
Highly paid professionals who can incorporate their practice can either take all of their income in the form of salary or they can leave profits inside the corporation to be taxed at 21%, then take the after-tax net as a dividend.
To equalize the tax treatment between taxable and pass-through businesses, the Tax Cuts and Jobs Act creates a new category of income called “qualified business income” (QBI) and allows the business owner to deduct 20% of that income, calculated on an activity-by-activity basis, from your taxable income for the year.
QBI includes net business income from sole proprietorships, partnerships, and S corporations. This could include your massage therapy business, electrical business or local boutique that you own and operate. It also includes pass-through income from real estate investment trusts, publicly-traded partnerships, and qualified agricultural coops. If your 2018 taxable income – after adjustments to income and itemized deductions – is over $157,500 ($315,000 for joint filers) your QBI deduction for each activity is limited to the greater of:
50% of the W2 wages timely paid on behalf of that activity, or 25% of the W2 wages plus 2.5% of the initial cost, immediately after acquisition, of all tangible property placed in service on behalf of that activity.
A little planning may help maximize the deduction.
If you currently operate a service business as a sole proprietor, have few or no W2 employees, and your taxable income is above the $157,500/$315,000 threshold, great job, but with these new times you may want to establish an S corporation and pay yourself a W2 wage.
If part of your activity involves personal services and part does not, segregate the non-service income into a separate activity. If your business utilizes independent contractors, make them W2 employees.
There are a lot of moving parts, especially for business owners. Be proactive, do some tax planning now to help you make the most of the new tax law and catch up on opportunities you may have missed under existing law, too. For small business owners the new law may just save you thousands in taxes